The federal watchdog for financial institutions is cracking down on cash exchange-traded funds, one of Canada’s most popular retail investments, by imposing capital rules that will ultimately lower the monthly yields the funds can pay out.
Cash ETFs, also known as HISA ETFs, are hybrid funds sold by independent investment companies that function like high-interest savings accounts but are publicly traded and offer much better interest rates – around 5.3 per cent annually. These rates are similar to the yields offered by guaranteed investment certificates, which are sold by the banks, yet investors in cash ETFs can withdraw their money whenever they choose. For GICs, the money must be invested for fixed terms.
The ease of withdrawal from cash ETFs frustrated some Canadian lenders, prompting the Office of the Superintendent of Financial Institutions to launch a formal review earlier this year. After six months of consultations, OSFI ruled Tuesday that Canada’s banks must change the way they treat the companies who sell cash ETFs.
The changes are technical, but under the new rules cash ETF yields are likely to drop by 0.5 per cent annually, according to TD Securities. While this change is not expected to decimate the product, it is a win for the banks that opposed these funds because cash ETFs will become less competitive relative to bank GICs.
In a statement Tuesday, OSFI superintendent Peter Routledge acknowledged the importance of innovation to a healthy financial system, but said OSFI’s “responsibility is to ensure the institutions it supervises manage liquidity risks prudently. This decision is consistent with established banking principles and reflects, in OSFI’s view, the appropriate liquidity treatment for these funding sources.”
Som Seif, chief executive of Purpose Investments, the fund company that launched cash ETFs in Canada a decade ago, took issue with that characterization. “Frankly, this is once again OSFI showing that they don’t care about the end Canadian,” he said in an interview.
Cash ETFs are some of Canada’s best-selling funds this year, with a total of $23-billion now invested, according to TD Securities.
With the new changes, there will be less pressure on the banks to offer better rates to their clients. Although the central bank’s benchmark rate has jumped to 5 per cent, high-interest savings accounts across the Big Six banks are often still paying around only 1.5 per cent annually.
Some lenders, such as Toronto-Dominion Bank TD-T, do not even allow their do-it-yourself investing clients to buy cash ETFs through their discount brokerage.
In its ruling, OSFI stressed the importance of stability for financial institutions. The fear with cash ETFs has been that investors could pull their money quickly if interest rates start to fall, and that could cause a problem for the banks because they have strict regulations on how much capital they must hold to buffer against things like loan losses.
But cash ETF providers, including Purpose, CI Financial Corp., Horizons ETFs Management (Canada) Inc. and Evolve Funds Inc., have argued the money in their funds is quite “sticky,” making it akin to retail deposits.
Because of the new OSFI rules, the money in cash ETFs – which gets invested in bank savings accounts with preferential rates to generate their yield – will have to be treated as wholesale deposits, not retail deposits. That means the banks will have to lower the rate they pay to the funds.
Cash ETFs are able to pay high interest rates because select banks offer them access to wholesale funding – that is, the banks pay the funds premium interest rates they would normally reserve for institutional clients, or for large orders. Similar rates would be available to wealthy retail investors who wanted to deposit millions of dollars.
This access has rankled some banks, The Globe has reported, because ETFs that offer premium rates to retail clients are likely to lure away customers from banks.
While OSFI’s ruling hinders the product’s attractiveness, the worst-case scenario of a complete ban on cash ETFs has been avoided. “The silver lining to this decision is we now have clarity in order to continue to build the business going forward,” Horizons ETF chief executive Rohit Mehta said in an interview.